Question

Problem 22-03

Merger Bid

Hastings Corporation is interested in acquiring Vandell Corporation. Vandell has 1 million shares outstanding and a target capital structure consisting of 30% debt; its beta is 1.35 (given its target capital structure). Vandell has $10.69 million in debt that trades at par and pays an 7.2% interest rate. Vandell’s free cash flow (FCF0) is $2 million per year and is expected to grow at a constant rate of 6% a year. Both Vandell and Hastings pay a 35% combined federal and state tax rate. The risk-free rate of interest is 6% and the market risk premium is 6%.

Hastings Corporation estimates that if it acquires Vandell Corporation, synergies will cause Vandell’s free cash flows to be $2.3 million, $3.2 million, $3.4 million, and $3.60 million at Years 1 through 4, respectively, after which the free cash flows will grow at a constant 6% rate. Hastings plans to assume Vandell’s $10.69 million in debt (which has an 7.2% interest rate) and raise additional debt financing at the time of the acquisition. Hastings estimates that interest payments will be $1.5 million each year for Years 1, 2, and 3. After Year 3, a target capital structure of 30% debt will be maintained. Interest at Year 4 will be $1.426 million, after which the interest and the tax shield will grow at 6%.

Indicate the range of possible prices that Hastings could bid for each share of Vandell common stock in an acquisition. Round your answers to the nearest cent. Do not round intermediate calculations.

The bid for each share should range between $___ per share and $___ per share.

If you could show me the excel I would appreciate it

Answer 1

We need to find wacc first

wacc= (D/V)*Kd*(1-taxrate) + (E/V)*Ke

D/V = weight of debt = 30%; E/V = weight of equity = 70%;

kd =cost of debt = 7.2%; Tax rate = 35%;

ke = cost of equity = risk-free rate + beta*market risk premium = 6% + (1.35*6%) = 14.1%

wacc = (30%*7.2%*(1-35%)) + (70%*14.1%) = 11.274%

----

Firm value = FCF1/(k-g)

where

g = growth rate = 6%; FCF1 =free cash flow in year1= FCF0*(1+g) = 2*(1+6%) = 2.12 million

Firm value = 2.12/(11.274% -6%) = 40.19 million ---- growing perpetuity formula

Equity value = Firm value - outstanding debt = 40.19- 10.69= 29.5 million

share price = Equity value/No of shares = 29.5/1 = 29.5 dollar (pessimistic value)

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Wacc without tax shield Wacc = (D/V)*kd + (E/V)*ke = (30%*7.2%) + (70%*14.1%) = 12.03%

Value of unlevered operations:

Equations	Year (n)	1	2	3	4	Perpetuity
	Growth rate g					6%
FCF5 = FCF4*(1+g)	FCF	2.3	3.2	3.40	3.6	3.816
FCF5/(Wacc-g)	Horizon value					63.28
	Total FCF	2.3	3.2	3.40	3.6	63.28
1/(1+Wacc)^n	Discount factor @ Wacc	0.895	0.801	0.718	0.642	0.642
(Total FCF*Discount factor)	PV of FCF	2.06	2.56	2.44	2.31	40.62
Sum of all PVs	Total PV	50

Value of tax shield:
Formula	Year (n)	1	2	3	4	Perpetuity
	Growth rate (g)					6%
I5 = I4*(1+g)	Interest (I)	1.50	1.50	1.50	1.426	1.51
	Tax (T)	35%	35%	35%	35%	35%
(Interest*Tax)	Tax shield (TS)	0.53	0.53	0.53	0.5	0.53
TS5/(Wacc-g)	Horizon value					8.8
	Total TS	0.53	0.53	0.53	.50	8.8
1/(1+Wacc)^n	Discount factor @ rsU	0.895	0.801	0.718	0.642	0.642
(Total TS*Discount factor)	PV of TS	0.47	0.42	0.38	0.32	5.65
Sum of all PVs	Total PV	7.24

PV of unlevered operations (a)	50
PV of Tax shield (b)	7.24
Intrinsic value of operations (c = a+b)	57.24
Current debt amount (d) (in $ mn)	10.69
Equity value (e = c-d) (in $ mn)	46.55
Shares O/S n (in mn)	1
Value/share (e/n) ($)	46.55 (optimistic value)

By considering maximum and minimum growth of the company, bid of share price should be between $29.5 per share and $46.55 per share.